Whatever happens with Republican tax reform, the mortgage interest deduction is in trouble.
It’s long been one an untouchable, sacrosanct tax breaks in the tax code. Even today, it remains too popular for President Trump and congressional Republicans to suggest eliminating it as part of their broader tax reform initiative.
Nevertheless, the past few months have revealed that the break is not an unalterable fact of the tax system. Instead, it is politically vulnerable.
Although both houses of Congress have steered clear of eliminating the mortgage interest deduction, both would dramatically lessen its effect on the economy, setting it up for elimination in the future. The House Tax Cuts and Jobs Act would halve the maximum size of the break, lowering the total amount of home debt on which interest could be deducted from $1 million to $500,000.
At the same time, academic evidence is accumulating that the break does not promote homeownership, which undercuts the main argument used by the housing sector to defend it.
In other words, the mortgage deduction, which the Treasury estimates would cost more than $1 trillion in revenues over the next decade if the law stayed unchanged, is more likely than ever to be on the chopping block, regardless of whether tax reform reaches Trump’s desk in the near future.
Opposition from the home industry
“The bills would eliminate or cripple the tax incentives for homeownership for the first time in over 100 years since the inception of the Internal Revenue Code for most people, but it would also drop the home values for everybody,” Evan Liddiard, the senior policy representative for the National Association of Realtors, told reporters as the legislation advanced.
Along with the National Association of Home Builders, the realtors have provided the greatest industry opposition to the GOP tax push.
Changes to the deduction are not the only reason they are flying their members to Washington to lobby against the reform bills. In fact, the Republican bills would pare several other tax breaks that subsidize housing.
The biggest hit to housing tax breaks would be an indirect one. Both bills double the standard deduction, a politically marketable move that would also have the effect of lessening the economic impact of many specific deductions.
Here’s how it works. Taxpayers have the option of deducting amounts from their taxable income for specific items that they spend money on, such as taxes paid to state and local governments, mortgage interest, charitable contributions, medical expenses, and more. Those are what are known as “itemized” deductions.
Alternatively, taxpayers can simply take a “standard deduction,” which allows a married couple this year to deduct $12,700 from their taxable income.
Republican plans would raise that standard deduction to $24,000.
“By doubling the standard deduction, as both the House and Senate bills do, only a fraction of Americans will take advantage of the MID [mortgage interest deduction], because they will no longer itemize,” said Elizabeth Mendenhall, president of the realtors group.
The bills also eliminate other itemized deductions, meaning that even fewer people on the margin will have enough total itemized deductions to make itemizing more valuable than taking the standard deduction.
Combined, those changes mean almost everyone will simply take the standard deduction. Today, 70 percent of tax filers already do so. Under the House legislation, 94 percent would, according to Congress’ nonpartisan Joint Committee on Taxation. In that case, the mortgage interest deduction would be as good as gone, home builders said after the GOP unveiled its plan in September.
To be clear, almost everyone would be better off taking the standard deduction. They would choose it over itemizing because it would provide a bigger tax break, and it would also simplify their tax affairs.
The housing industry’s argument, though, is that by winnowing the number on itemizers, the tax code would contain less encouragement specifically to buy a house. People would get their tax breaks regardless of whether they took out a mortgage, lessening the incentive to do so. In other words, they could get tax breaks even if they don't buy a house. Homeownership would decline, placing a drag on the economy.
There is merit to that argument. “I think there’s a legitimate concern that either of these tax plans really might reduce the incentives of households to buy new houses,” said Ralph McLaughlin, chief economist at the real estate listing site Trulia.
Newer homes tend to be more expensive, McLaughlin noted, and so are more likely to exceed the $500,000 threshold for interest deductibility in the House bill. Also, both bills would curb deductions for state and local property taxes, making such home purchases more costly. The House version would allow up to $10,000 in deductions for property taxes, while the Senate bill would eliminate such deductions altogether.
Other housing incentives would get axed in the GOP plans. In the House bill, for instance, more homeowners would be taxed on the appreciation of their homes when they are sold. Taken altogether, the changes could lead to a “cooling” in high-end real estate markets, McLaughlin said, as more people hold onto their homes for longer.
Even if that would be bad for builders and realtors, who profit from hot markets, it’s not necessarily bad policy overall.
“Home values need to fall,” said William Gale, a tax expert at the Brookings Institution and critic of the mortgage deduction. “They can fall gradually, but they need to fall. The home mortgage deduction is artificially propping them up.”
Opponents of the mortgage interest deduction have been surprised by Republicans’ success, so far, in seeking to limit the break even over housing interests’ warnings that it will tank home prices and destroy the economy.
Mechele Dickerson, a law professor at the University of Texas, has for years advocated reforming the deduction and putting greater federal focus on rental assistance. She said she was “shocked” at the big and sudden deterioration in the deduction's political fortunes.
When she has suggested crimping the break in past years, she said, “the reaction would be somewhere between 'you’re insane' and 'no politician would ever touch it.'"
The break has been part of the Internal Revenue Code since its inception in 1913. In the 1986 tax reform, President Ronald Reagan left it alone, even as his legislation eliminated deductions for interest on credit cards and other consumer loans. In 2005, a panel appointed by President George W. Bush to study tax reform proposed ending the mortgage interest deduction and replacing it with a more limited credit, but that effort stalled in 2016. Only one presidential candidate, Ben Carson, who is now secretary of Housing and Urban Development, called for an end to the cherished tax break.
In the presidential election, in New Hampshire, Trump defended the break, saying, “You want to see a crash? Try that one.”
Now, however, the break looks much more touchable.
If either Republican bill passes, far fewer people will claim the deduction. The vast majority of its benefits flow to taxpayers earning more than $100,000, with almost half going to those earning over $200,000. If a GOP bill passes, the distribution will skew further because most people would seek the standard deduction rather than itemizing. This would make the mortgage interest deduction politically isolated, and allow it to be demagogued as "a giveaway to the rich".
“If Congress passes tax reform legislation that doubles the standard tax deduction, the mortgage interest deduction would become even more regressive than it is today. Only the highest income earners with the largest mortgages would still benefit,” said Diane Yentel, president of the National Low Income Housing Coalition. Yentel has long advocated reforming the deduction and redirecting savings to programs that benefit lower-income renters. The case for that switch would be “even more powerful” if the Senate bill passed, she said.
Even if neither bill passes, future Congresses will worry less about taking on the deduction and the housing lobby, Dickerson said. “There will be more of an appetite going forward,” she said. “If nothing else, people are hearing the statement and the numbers coming up over and over that the mortgage interest deduction disproportionately benefits high-income taxpayers.”
At the same time that Republicans have taken the plunge on housing tax breaks, the academic case against the mortgage interest deduction has strengthened.
A paper released in June by Massachusetts Institute of Technology Economics Prof. Jonathan Gruber and two others found that the break has no effect on homeownership, and instead only increases home sizes and mortgage debt. The paper used a kind of natural experiment that arose after a 1987 tax reform in Denmark, which changed the value of the deduction for high-income earners, but not for others, providing a point of comparison. Gruber told the Wall Street Journal that the study was “a nail in the coffin of the idea that this tax break affects homeownership.”
Another new study, set to be published in the American Economic Review, examined the impact of eliminating the deduction in a model of the housing market that includes the possibility of housing prices. The authors, including a staff economist at the Federal Reserve’s Board of Governors, found that “eliminating the mortgage interest deduction [would] cause house prices to decline, increase homeownership, decrease mortgage debt, and improve welfare.”
Another blow to the tax subsidy for home loans was the 2016 publication of Evicted, a book studying the prevalence of evictions and the depths of the rental crisis written by the Harvard sociologist Matthew Desmond. Desmond helped run a survey uncovering the fact that evictions are far more common than generally understood. He also connected those evictions to human suffering by spending several years living in poor Milwaukee neighborhoods, documenting the travails of poor renters in painful detail. Desmond has since criticized the federal government’s subsidies for homeownership and called for a federal guarantee for housing.
That is the basic trade-off that Yentel, who doesn’t favor the GOP bills because they cut taxes on the high end rather than funding new housing programs, called for reassessing. “Three out of four households in need of housing assistance are turned away because of a chronic lack of funding,” she said. “And yet, at the same time, $3 of every $4 that the federal government spends to help Americans buy or rent their homes goes to higher income people — through the mortgage interest deduction and other homeownership tax benefits — who would largely be able to live in affordable and stable homes without this federal assistance.”